Free banking was robust and effective

Steve Davies

29 April 2013

In an earlier blog post, Philip Booth discussed the likely scenarios for Scottish monetary policy in the event of Scottish independence and the difficulties, both political and economic, associated with these. What can be very useful is to add historical perspective and to see how things worked out in the past, given that Scotland has an interesting monetary and banking history which is very different from that of England.

Before 1707 Scotland had its own currency, the Pound Scots, created by David I in the 12th century. Regular depreciation meant that by the seventeenth century it had an exchange rate with Pounds Sterling of twelve to one. There was some circulation of English pounds alongside Scottish pounds after the Union of the Crowns in 1603 and both units of account could be used in contracts (although the great majority were in Pounds Scots). In 1707 the Act of Union took place and as part of the terms of the agreement the Pound Scots was abolished (although it continued to be used as a unit of account). Scotland thereafter was in both a political and currency union with England and Wales while before that time there had been a partial political union but no currency union.

However, the situation after 1707 was not a full monetary and banking union of the kind we have today. While England and Scotland used the same money (Pound Sterling) they had very different monetary and banking systems governed by clearly different laws. The reason for this was that while the Act of Union had merged the Scottish and English Parliaments and subsequent action had abolished the Scottish Privy Council (effectively Scotland’s executive branch), the legal system remained completely separate and Scotland was governed by its own distinct legal system and courts (as it still is and always has been).

In Scotland, unlike England, there was no officially chartered bank with public responsibility for the currency and a possible lender of last resort role. Instead you had free banking where the circulating medium consisted mainly of paper notes issued by private banks. One bank, the Bank of Scotland, had held a monopoly on note issue from its chartering in 1695 but this lapsed with its charter in 1716. Initially there were just two banks, the Bank of Scotland and Royal Bank of Scotland but the number grew rapidly. By 1750 there were 14 firms, the number rose to 23 by 1765 and 32 in 1769. Not all of these issued notes but a large number did. The notes were exchanged between banks through a clearing system and were convertible on demand (although until 1765 there was the additional option of fixed term delayed conversion with interest). In the entire history of the system there were only two failures due to overissuing of notes or credit – in marked contrast to the fragility of the English country banking system of the same period. There was also sustained competition and innovation with a move after 1810 to an extensive branching system (again unlike England).

As Adam Smith and many other contemporary observers pointed out the system was robust and effective and played a major part in Scotland’s transformation from one of the poorest and most backward countries in Europe to an economic powerhouse. In 1750 Scotland’s income per capita was half that of England, yet by 1850 is was equal to England’s – despite sustained growth in England as well as Scotland. This monetary independence ended with the passage of the Scottish Banking Act of 1845 (following on from Peel’s Bank Act of 1844), which took away the right of free note issue and made Scottish banks explicitly subordinate to the Bank of England.

So at present there seem to be three options for an independent Scotland – joining the euro (politically impossible even if desirable), a currency union with the UK (this would work but would mean that independence was illusory), or a separate currency which would have the consequences Philip Booth outlines. History suggests there are two other options. One would be to have two currencies circulating side by side as between 1603 and 1707. Another would be to revert to the system described as it existed between 1716 and 1845, and have a free banking regime in Scotland within a currency union. Philip Booth has explained that this is not possible if Scotland and the UK remain part of the EU. It would also be very difficult if there were banks operating in both England and Scotland while England had a deposit insurance scheme and a central bank with currency management and a lender of last resort role. One solution to that would be to say that Scottish banks could only operate in England and Wales through subsidiaries. Alternatively we could even try adopting the Scottish free banking system throughout the UK. Now wouldn’t that be a reversal?

Nice post. The fourth paragraph seems slightly misleading though, it seems to imply that instability in the English banking system in the early 19th century was due to the BoE's public responsibility for the currency and it's lender of last resort role, however, I'm not entirely sure it played this role until later in the century, after Bagehot wrote the central bank manual. In my opinion, the main cause of instability around this time was the law that restricted banks to a minimum of 6 shareholders, repealed around 1825.
With the regard to free banking in general, are there any examples where free banking systems have had to cope with wide scale deleveraging, much like we've been seeing over the last few years?

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